A firm has to choose an appropriate mix of equity of debt in such a way that it maximizes the value of the firm.
Any change in the debt-equity mix will have an impact on the value.
It has been observed that adding debt to the capital structure of a firm increases the value of the firm upto a point. This point corresponds to the optimal capital structure. Beyond this point any increase in the debt the value starts decreasing again.
Let us understand this in more detail.
According to a Modigliani and Miller (1958 article), if there are no corporate taxes, the mix of debt and equity does not matter and does not have any impact on the value of the firm. The value of the firm is simply equal to the operating income divided by the overall cost of capital.
The reason behind this is that any benefit that arises from the lower cost of debt is offset by the increase in the cost of equity caused by borrowing.
However, thinking about businesses without corporate taxes in unrealistic. Modigliani and Miller revised their theory in 1961 and this time assumed the presence of corporate taxes.
If we assume that corporate taxes exist, the theory that the value of the firm doesn’t depend of the capital structure doesn’t hold good.
In the new article, they recognize that with the increase in leverage, the value of the firm will increase or the cost of capital will decrease. This is because the interest paid on debt is a deductible expense.
Because there is no tax to be paid by the bondholders, the value of the leveraged firm is higher than the unleveraged firm.
The increase in the value of the leveraged firm will be equal to the present value of the tax shield due to tax savings given by the tax deductibility of interest expense on debt.
This is also known as the trade-off theory. The trade-off theory says that companies have optimal debt-equity ratios, which they determine by trading off the benefits of debt against its costs.
One benefit of debt as we saw is the tax deductibility. More recent versions of the model also attempt to incorporate Jensen’s “free cashflow” argument, in which debt plays a potentially valuable role in mature companies by curbing a managerial tendency to overinvest.